Saturday, July 09, 2011
6:55:07 PM EDT

Jobs Ate Our Rally

by
Jim Brown

The ADP upside surprise produced a significant short squeeze rally but the Non-Farm Payrolls on Friday was equally market moving only it was in the opposite direction.

Market Statistics

Morgan Stanley said, "The June payrolls are an unmitigated disaster. Every facet of the data is sharply worse than anticipated." That pretty well sums up the Non-Farm Payroll report. The headline number showed a gain of +18,000 jobs compared to consensus estimates last weekend at +88,000 and radically increased estimates after the ADP report to as much as +175,000 jobs. Obviously analysts missed this one significantly.

It was actually worse than the +18,000 number suggests. The number for May was revised lower from a gain of +54,000 to only a gain of +25,000. In reality May was revised lower by more than the gain in June. The April gain of +232,000 was revised lower to +217,000 for a total decline in previously reported numbers of -44,00 jobs. These numbers are seasonally adjusted using the BLS "birth-death" model for guestimating the creation and failure of new businesses. If you back out the B/D adjustments the economy lost -113,000 jobs in June.

You want to see something really scary? (Twilight Zone Movie) The separate Household Employment Survey, where we get the unemployment rate, showed a LOSS of -445,000 jobs and increase in unemployment of +173,000. This pushed the unemployment rate up to 9.2% for the third consecutive monthly gain. That represents 14.1 million unemployed workers.

The broadest measure of unemployment (U-6) rose to 16.2% (24.85 million) and the highest since June 2010. That includes discouraged workers, those whose unemployment benefits have expired and those working part time because they can't find a full time job. The labor force participation rate fell to 64.1% and the lowest level since 1984.

The average duration of unemployment increased to 39.9 weeks but a large and growing number have been out of work more than two years.

Haver Analytics produced a chart showing the average length of unemployment dating back to 1948 and it is not pretty. Typically bad recessions saw unemployment terms top out around 20 weeks. At the current rate it will be over 40 weeks by the end of July and still rising. The outlook for putting everyone back to work is grim since it would take a minimum of four years at +250,000 jobs a month just to make a dent in the total and put 12 million people back to work. That would be only half of the current U-6 unemployment. The U.S. has to create 150,000 jobs per month just to stay even with population growth, graduations and immigration. In a month like June at +18,000 we are really falling farther behind. If we only added 18,000 jobs per month for the next six months we would actually see an increase of another 900,000 unemployed workers to the work force.

Haver Analytics Unemployment Duration Chart

The only thing that will help rectify this situation is the retirement of the baby boomers over the next decade. Starting in 2011 and continuing for the next 19 years more than 300,000 boomers reach age 65 every month. Obviously not all are going to quit working the day after their 65th birthday but quite a few will take that long walk to the parking lot for the last time. This will help create new hiring to fill those positions. However, because most boomers have not saved for retirement more than 40% claim they will work until they drop.

On a side note the social security system began paying out more in benefits in 2010 than it received in contributions. In 1950 there were 16 people working for every person on social security. Their contributions supported the one retiree. In 2010 there were only 3.3 workers per retiree. By 2025 that will decline to TWO workers. Interest costs on the national debt, social security payments and Medicare will consume 92-cents of every dollar of federal revenue by 2019. This is regardless of what happens to the debt limit talks in July.

Back to the present the majority of job losses in June were from state and local governments. They cut 39,000 jobs in June. The financial sector cut -15,000 and construction -9,000. Manufacturing gained +6,000 and retail +5,200. Without the hits from state and local governments the private sector created +57,000 jobs. The government sector has cut 911,000 jobs in the last 13 months. That includes 250,000 who were temporary census workers. There were -321,000 federal jobs, -306,000 state and local government jobs and -155,000 were education jobs.

Analysts believe the uncertainty over Europe's debt crisis, the debt limit crisis in Washington, rising fuel prices, the continued hit from the Japan supply chain and the May double dip recession scare were to blame for the lack of jobs in June. Whatever the reason those analysts were quick to lower estimates for future job growth. Moody's cut their estimates for the rest of the year to less than 200,000 a month even though they expect the economy to do better. They still expect job gains in 2012 to accelerate sharply. Seems to me back in 2010 everyone was expecting job gains to accelerate in 2011. Did we just lose a year? Will we be saying the same thing about 2013 when we are half way through 2012?

Non-Farm Payroll Chart

You may remember back when President Obama was trying to get the $800 billion stimulus bill passed the White House prepared the following graph showing how bad unemployment would be both with and without the stimulus plan. The good folks at E21 have updated the chart with the actual unemployment rates since Christina Romer initially produced it. The President promised unemployment would not go over 8% if the stimulus were passed. In reality if has been close to 10% for quite a few months.

Economics21.org Updated Unemployment Chart

Remember all those shovel ready jobs we were promised in the stimulus sales pitch? Two years later much of the money remains unspent and the shovel ready jobs did not appear. Instead there were more than 9,000 earmarks otherwise known as special pork projects included in the bill. These are things like the $3 million allocated to study the drinking habits of prostitutes. The White House claims the $800 billion bill created or "saved" three million jobs. That works out to a cost of $266,000 per job. Since we can pretty much bet those workers are not receiving $266,000 in salary it seems to be an awful large number to create a single job and that assumes you buy the White House claim of three million jobs. More than 650,000 government jobs cut over the last year were cut because the stimulus funds expired and there were not enough taxes to support them.

Contrary to public perceptions the government can't create jobs except by increasing the size of the government and adding government workers that you and I have to pay for with our taxes. We don't need bigger government as a make work program for the unemployed. The government needs to get out of the way and reduce restrictions and uncertainty over the business community. Only then will businesses feel comfortable about hiring.

There are six million corporations in the U.S. that employ one or more workers. Over 90% have less than 20 workers and they are run by small entrepreneurs making not much more than a $100K per year. When you raise taxes on small businesses or complicate their lives with unnecessary red tape and government mandates you are reducing jobs. Small business owners don't have the luxury of large cash flows to pay things like government mandated health care. In every survey on the potential impact of the healthcare law the majority of business owners said they would have to cut employees to raise the money to pay healthcare for the remaining workers. That impacts 90% of the employers in the U.S. and is just one example of why we are not seeing new jobs created. Employers are scared of what is coming and they are reducing head counts for a multitude of reasons.

I am sure Ben Bernanke probably had a very bad Friday. The rising unemployment for the third consecutive month suggests the Fed could be back with another stimulus program soon. Their dual mandate for rising employment and stable prices is failing. The appetite in Washington for a QE3 program is nonexistent. In the current fiscal environment any form of stimulus carries a negative connotation. The Fed does have ways to stimulate business other than low rates and quantitative easing but they are less desirable. One way they have discussed is to discontinue paying banks interest on reserves parked at the Fed. They are not paying much but it is still a risk free investment on something just under $1 trillion in reserves.

If they stop paying interest or even begin charging interest on those reserves it would force the banks to put the money to work elsewhere in places like construction loans or mortgages. The problem there is the credit quality. The current bank rules prevent loans to anyone with less than spotless credit and those types of borrowers have no trouble getting loans today so it is questionable how much those reserve changes would help.

Lawmakers should not be trying to find ways to raise taxes in a declining economic environment. Raising taxes on businesses and high-income individuals simply limits the amount of money left to invest in new ventures that will hire new workers. The government needs to pass a long-term incentive for businesses that will guarantee them a lower tax rate for years to come so they can plan for the future. The U.S. has the second highest corporate tax rate in the world and that makes it beneficial for companies to hire overseas rather than in the USA. Lawmakers should also allow U.S. corporations to bring money back into the U.S. without being taxed twice. There are estimates of as much as $200 billion in profits sitting in overseas accounts because corporations can't bring their profits back to the U.S. without double taxation.

There is almost no way the debt limit problem can be solved without additional layoffs. Any cut in spending will require further layoffs. We are facing a period of austerity that will not be even close to what Greece is going through but it will still result in a further slowing to the economy. You can't take $4 trillion out of the economy over the next decade without leaving a lot of holes and harming a lot of lives. Unfortunately it needs to be done and we will have to work through it. Analysts estimate any material debt limit compromise will reduce GDP by -1.5% per year for the rest of the decade.

Stupid government moves like the permit moratorium in the Gulf cost us between 35,000 and 55,000 jobs according to the governor of Louisiana. Nine rigs and their support staff left the Gulf for lack of work. It will be years before they come back because they now have new contracts elsewhere. It is not like we don't need the oil! The EIA has cut production estimates for the Gulf in 2012 by -335,000 barrels per day as a result of the permitorium. That means we will have to import that oil at the cost of $1.1 billion a month that we will be paying to countries like Venezuela, Nigeria and Saudi Arabia. Wouldn't it be better to produce our own oil and create our own jobs? Every government action has a reaction.

Another economic report on Friday was the Wholesale Trade for May. Wholesale inventories rose by +1.8% compared to estimates for a +0.7% gain. The April number was also revised higher from +0.8% to +1.1%. The rise in inventories was caused by a sudden decline in sales of -0.2%. That was the first decline since February and only the second in the last year. Sales rose by +0.5% in April and +3.0% in March. Some of the gain in inventories was also related to the snapback from the Japan supply chain break.

The rise in inventory and decline in sales was ignored to some extent because this was for the May period and therefore a lagging report. The market has already priced in the May soft patch but this will be a problem if it continues in future reports.

The economic calendar for next week is dominated by the FOMC minutes on Tuesday, Bernanke testimony on Wed/Thr and the PPI/CPI on Thr/Fri. The FOMC minutes may tell us what the Fed was thinking about as an alternative to QE3 during the June meeting. However, the minutes have less impact since Bernanke held the post-meeting press conference.

The price indexes are expected to show declines in inflation thanks in part to the decline in oil prices. There should be nothing in these reports that will worry the Fed or delay any future stimulus. Inflation is not a factor today.

Ben Bernanke will give his Semiannual Monetary Policy Report, formerly the Humphrey Hawkins Testimony, to Congress this week. The House testimony will be on Wednesday and he repeats it to the Senate on Thursday. I expect nothing new to be divulged but the testimony will be prime time viewing on stock TV. You never know when a specific comment will spike or tank the market.

Economic Calendar

The biggest stock news for next week will be the start of the Q2 earnings cycle. Alcoa (AA) is the first Dow component to report and that will happen on Monday. Marriott and Yum Brands will report on Wednesday. The biggest events will be the JP Morgan and Google earnings on Thursday. Google is expected to earn $7.86 for the quarter and they typically have major moves after they report. Next week should be no different. Expect a major move for Google.

JP Morgan will be the first major bank to report and with all the mortgage problems, charge backs and suits in the industry there is no telling what they will say. Analysts will be looking to see if lending has increased at all. The banking sector has been seeing existing loans mature and fall off the books but new loans are difficult to do so cash is piling up. Cash produces no revenue so analysts will be looking at the new business components. Citibank will report on Friday and they are expected to increase earnings by about 30%.

Google (GOOG) fell -$14 on Friday after the company was cut by Morgan Stanley from overweight to equal weight. (Buy to hold) and the price target dropped from $645 to $600. Google closed at $532. MS also cut full year earnings estimates from consensus at $40 to $34. MS said aggressive hiring plans, rising competition and heavy spending on Chrome and other products would narrow margins. Google is on track to hire 7,000 this year and well above the prior estimate of 4,000.

Google Chart

Airlines rebounded after the ugly jobs numbers because the lack of jobs suggests lack of demand for oil and oil prices in the U.S. dropped more than $2 per barrel. U.S. WTI closed just over $96 and right at support. Airlines initially fell on the jobs news because that suggests fewer travelers but rebounded slightly as oil prices declined.

Brent crude only declined 26-cents because weak jobs in the U.S. does not equate to lower demand in Europe. There were also notes passing in the market that tanker loadings in late July and August were going to drop due to falling production in the North Sea. This has been a problem for a couple years as depletion in the North Sea accelerates and production declines.

U.S. WTI Crude Chart

Brent Crude Chart

Gold and silver prices rallied again as a flight to quality hedge and on worries the debt crisis in Europe is not over. Comex gold rallied $14 to $1544. However, gold denominated in Euros rallied to â‚¬1,083 and a new nominal high. U.S. gold has rallied +$57 in the last week. Silver gained another 15-cents to $36.68 and ever so close to breaking through that resistance at the 100-day average at $37.

Gold Chart

In the U.S. we may feel like the Greece problem has disappeared. In reality Greece is still in the news but only at a lower volume level until the next crisis appears. The problem in Europe now is the worry about who will be next. The country indexes have been very volatile and some of them are dropping like a rock. For instance the Milan index declined -685 or -3.47% on Friday. The index is down -11% over the last three months with much of that decline in recent weeks. They saw a bounce last week after the Greek vote instilled a short-term burst of optimism but reality has returned. These countries either can't borrow in the open market or the rates are so high they can't afford the interest. Every analyst is confident Greece will eventually default and it will lead to other defaults of the weaker countries. This is pushing rates higher along with precious metals as a hedge.

FTSE MIB Italy Index Chart

Another data point worrying the market is a rapid increase in auto inventories. Actually it is a buildup of full size trucks. GM said it had 122 days of inventory as of the end of June. That is about 50% higher than the preferred level of 80 days and well above the industry average of 99 days. Chrysler has 93 days and Ford 79 days. There are three problems. First is the price of fuel and consumers are staying away from lower mpg vehicles. Secondly when the Japan quake occurred dealers canceled many incentives because of lower inventory while they waited for parts. Unfortunately the price of oil had already risen and buyers were focused on higher mileage vehicles instead of trucks. The last problem is buyer credit. Full size trucks carry a big sticker price and financing a $40K to $60K truck is not something every household can handle.

To solve this problem the automakers will probably put new incentives in place to spur sales. Current buyer incentives are currently $5,350 for the GMC Sierra, $4,880 for Silverado, $4,450 for Dodge Ram, $3,750 for Ford's F-series and $2,654 on the Toyota Tundra. If inventories don't decline soon and fuel prices continue to rise long term there is going to be a massive fire sale by year-end. Higher incentives cut into profits and automakers have been reluctant to raise the offers. Profits average $5,000 to $6,000 on a full size truck so they don't have a lot of room to maneuver. Analysts believe GM will cut truck production in Q3 to be 65,000 lower than Q2. That would cost GM about $500 million in lost profits.

GM Chart

The average vacancy rate for large U.S. shopping malls hit 11% in June and that is the highest level in the last 11 years and only 0.1% above a 20 year low. Regional mall vacancies rose to 9.3% and the highest level since 1990. The vacancies are a result of retailers pulling back from their aggressive expansion prior to the recession. Consumers have far less cash since they can't depend on their home equity as a personal ATM.

At regional malls there were many store closings for the anchor tenants and that loss of traffic prompted other specialty stores to close. In many cases the loss of an anchor tenant allows smaller stores to break their lease. Rents are flat to down with strip mall rents averaging $19.03 per square foot gross and $16.54 net after free months and other rental incentives. All those empty stores each represents dozens to hundreds of out of work employees.

Earnings begin next week and with the exception of a couple sectors they are not expected to be outstanding. S&P now expects a year over year earnings growth of +12.7% with revenue growth of +10.1%. However, guidance is not expected to be good. The soft patch has caused corporations to scale back expectations for the rest of the year and that will be reflected in the guidance they give with earnings. The table below shows the expected earnings growth for each of the ten major sectors on the S&P. Materials and Energy are by far the outstanding performers. If you took them out of the equation the rest of the S&P would be closer to 4% earnings growth. For me this is the Achilles heel for this quarter. The 12.7% earnings growth that is quoted so often in the press does not factor in the breadth of the earnings and the lackluster performance by six of the ten sectors. I am wondering if this will come out over the next several weeks or will the market cheerleaders keep glossing over the details?

S&P Q2 Earnings Growth By Sector

Despite everything I wrote above I believe Friday was bullish. It was bullish because the market did not crater even after a nearly 800-point gain in the Dow over the last eight days. By all rights we should have dropped -200 points on the jobs news and closed at that level or lower. To only lose -62 Dow points after an 800-point gain is phenomenal.

Volume was very low at 5.8 billion shares and the lowest since June 20th. Low volume on a down day is a bullish signal. Coming after that big gain is even more bullish.

I believe everyone who has been watching the rally since the 20th and cussing themselves for not boarding the bus at a lower level is thinking this weekend that Monday will be their opportunity.

The retail trader does not believe in the market or the rally. In June more than $20 billion was withdrawn from stock mutual funds. That is the most in a single month since October 2008 and on Thursday the markets were less than 1% from new highs. The sell in May crowd has been laughing at the market for two months. Now they have to be rethinking their position.

We are so close to those new highs the bullseye target is growing larger by the minute. For the bulls to give up this close to the goal would be unsettling. It would also create a possible head and shoulders top but we will deal with that in a couple weeks if it comes to pass.

The S&P declined to 1335 intraday and that turned into strong support on Tuesday and Wednesday. It is exactly where I would have scripted a pullback if I had that capability. The next material level would have been 1320-1325.

There was only a small amount of buying starting at the 11:AM low but it was persistent with a spike in the last hour of trading. I believe that spike was short covering and not a sudden desire by traders to get long over the weekend. More than likely it was shorts scared to be short over the weekend. With opening gaps the rule in recent days they probably did not want to be short with the president and party leaders meeting on Sunday to hammer out their differences. An announcement of a deal to end the debt limit stalemate could produce a 250-point spike on Monday. I definitely don't think it will happen but I think shorts were not willing to bet against it. Politicians always wait until the last minute in the hopes they can coerce one last bit of compromise out of the other party and milk the process for maximum gain.

The S&P closed at 1343 and managed to get back over that 1340 level that proved to be resistance earlier in the week. That is also a positive but it is not a guarantee of future performance. I am afraid I am reading positives into the charts because I want to believe the unexpected rally will continue. Because that troubles me I want to pay close attention to the market early next week. If we are going higher it should happen right away. The longer we loiter in the 1335-1340 range the more likely we are going lower. These rallies are impulsive more than rational. Once rational thought returns the odds of a continued rally begin to decline.

The temporary Greek resolution, suddenly improving economics and the shock of the ADP report combined to crush the shorts. The shock of the Non-Farm Payrolls caused a temporary decline with a decent rebound but it is entirely possible traders are in stunned disbelief rather than simply buying the dip. A market in motion tends to stay in motion so there is some momentum that tends to ignore bad news on the first reading. As the news and analysis is repeated in the days ahead that momentum may fade.

It is the equivalent of suddenly swerving to miss a pothole at 75 mph and not succeeding. You continue to flow with the traffic for a while trying to feel through the steering wheel if everything is all right. After a few hundred yards you begin to feel the drag and loss of control as the tire begins to go flat. You head for the shoulder and stop to change it. Had there been no telltale signs of a flat you would have continued down the road to your destination.

The jobs report was our sudden pothole and the pause on Friday was the questioning period where traders are getting the feel of the market to see if we lost a tire. The weekend news is going to be full of gloom and doom regarding jobs, the economy and the debt limit crisis. Investors less informed than Option Investor readers will be getting their news from the mainstream press over the weekend. Since bad news sells better than good news you know how the press will spin the story. Actually the majority of investors will be oblivious to the entire event. Only a very few actually pay attention to the economic news.

If enough investors hear the negative news then we could have a challenge on Monday that leads to investors pulling off the road to change the flat and wait for a new entry.

For the last three weeks I have been writing about the historical trend of a quarter end window dressing rally that extends through the first week of July. Historically that rally begins to fade during the second week and the July lows are later in the month. Because of the convergence of events we saw a much stronger rally than normal. We are within shouting distance of new highs but the calendar is wrong. There is no reason we can't go higher with earnings as our supporting reason but I remain skeptical.

After looking at the facts I am going to take a cautiously bullish stance for early next week. As we get some earnings behind us we should be able to make a more rational decision on the future trend. The key day will be Thursday with JPM and Google reporting. I would just like to get to Thursday without any material decline then take our cue from those reports.

S&P Chart - 20 Min

S&P Chart - Daily

The Dow punched through 12,600 to touch 12,750 on Thursday. Friday's job shock knocked it back to 12,567 at the open and a loss of -150 points. The dip was immediately bought and despite large declines in CAT, UTX and BA the Dow recovered to end down only -62 points. It may not have been a win but it was a strong effort. We could just as easily ended down triple digits instead of moving higher into the close.

The Dow's direction on Monday could be the result of Alcoa's earnings or any number of outside news events. The bloom came off the rose on Friday but the petals are still attached. We need an impulsive move higher early Monday or undecided investors could begin to reduce positions. Overhead resistance if 12,800 so plenty of room to move.

Dow Chart

The Nasdaq actually traded in new high territory on Thursday but could not close there. The sell off on Friday knocked -40 points off the index at the open but 30 of those points were recovered by the close. The rebound occurred without the help of Google (-14). All the other majors (NFLX, PCLN, AMZN, WYNN, AAPL) finished with a gain. F5 Networks was the exception to the trend. The failure of the Nasdaq to sell off significantly is bullish. Overcoming the -$14 drop in Google was bullish. The index is still over extended but the bulls are clearly in control.

Resistance remains 2873 and support is 2830.

Nasdaq Chart

The Russell 2000 spiked over 860 intraday on Thursday before closing at 858. Friday's decline was minimal and there was a little more elevation on the afternoon rebound than on the other indexes. This suggests fund managers were bargain hunting in the small caps. The prior long-term high from 2007 at 855.77 is the same resistance level that held in April and late May. If the Russell can close over 860 I think that will energize buyers and a move to a new high over 865 would be very bullish. However, this resistance is exactly where you would expect the Russell to fail. Market action on Monday is going to be very important for establishing the trend for the week.

Russell 2000 Chart

I have very mixed emotions about next week. As an option expiration week we could see some additional volatility in addition to the early earnings and the Bernanke testimony. I could also see us trading in a range as investors absorb the impact of the jobs report and the events of the week. I spent a lot of time analyzing the indexes and trying to project the impact of the coming events. I ended up with a cautiously bullish view for the week. This was based on the Russell and the Nasdaq charts rather than the S&P. Obviously there is never any guarantee and once the market opens on Monday and the news for the week begins to flow, all bets are off.

I believe the earnings guidance is going to be the key. If the guidance is weak we could see the markets move into a wait and see mode while the July economics play out. This would be the normal historical pattern. The only difference this year is the proximity to the recent highs. Those highs are a siren's call in an attempt to lure stocks higher. There is no real justification for a continued rally. With earnings outside of energy and materials running at a +4% growth pace, guidance expected to be lackluster and economics a wildcard there is no fundamental reason for a rally to new highs. I think that will eventually be our downfall.

Last week I said, "I need a dip to buy and I would be skeptical of a one-day wonder." Friday was our dip but so far it is just a one-day wonder although it did reach initial support. How the market reacts on Monday will be critical.

Monday is the absolute last day to take advantage of our Independence Day special. Readers can subscribe this weekend at the cheapest prices of the year using our July 4th package special. This is a significant discount over the monthly prices and we are offering a choice of free instructional videos to those that take advantage of this special.